As of the close of May 24th the S&P 500 is -4% MTD and +12.7% YTD, and the MSCI World is -4.4% and +10% YTD.
- After touching the all-time-high of 2945 at the end of last month, US equity markets (S&P 500) have corrected around -4% led by the negative headlines on the back of trade war fears, ignited by the decision of the Trump administration to impose higher tariffs to Chinese imports. The growing list of collateral damage from the ongoing US/China Trade War, extended to ZTE, Huawei, HIKVision, their related supply chains, and, even pandas from the San Diego Zoo (yes, China is demanding Pandas loaned to the San Diego zoo, back).
- Since Trump announced that the rate on $200bn of goods imported from China would increase to 25% on May 10th, the S&P is just down -3% — probably giving us some clarity of the positioning picture, as investors seem to have been already fairly well hedged versus what we saw during the tumultuous times of 4Q18. Frankly the fact that it was not down more, has surprised us, in the face of generally negative news flow.
- Looking back to where we were in the last IC, it is truly amazing that a few inflammatory tweets can change sentiment so drastically. We’ve gone from a US/China deal being fairly consensus just a few short weeks ago, to a near-term resolution being speculative at best. Based on the news flow it sounds like many believe we could be in for a long, drawn out process.
- President Trump’s tariffs were initially seen as a tool to force other countries to drop their trade barriers, but they increasingly look like a more permanent tool to shelter American industry, block imports and banish an undesirable trade deficit. More than two years into the Trump administration, the United States has emerged as a nation with the highest tariff rates among developed countries, outranking Canada, Germany and France, as well as China, Russia and Turkey.
- Beneath the surface, the market has been more discerning and internal rotations continue to support the index, as price action paints the more cautious picture. Last week saw continued rotations out of Cyclicals (-4.3% on the week) and into Defensives (+1.2% on the week). Also, since May 3, S&P Utilities are up +2.1%, while Consumer Discretionary and Info Tech led the way down, -5.8% and -7.2% respectively. Bottom-line, it appears as though investors are taking a step back to say “Let’s not be out of the market but let’s be thoughtful.”
- The picture on US inflation might also be changing. Tariff escalation risk has risen and each progressive tranche of tariffs increasingly affects consumer goods. The final tranche is 68.5% consumer goods & auto/parts—the highest percentage of the three tranches. It is possible that inflation markets have not yet priced in the impact of tariffs, and instead appear complacent. Analysts at Morgan Stanley find that the 10% tariffs last September likely added 10bp to CPI, and extrapolation would suggest 25% tariffs could be worth 25bp on CPI.
- While consumer goods bear the brunt of the trade-related supply chain impact, it does not stop there. Many view tariffs could cost 1.0%-1.5% of net income for the S&P 500 for 2019. Key sectors at risk include US (IT hardware, Hard and Soft Goods, Autos, & Auto Suppliers), EU (Capital Goods), and Asia Tech, Asia Autos & Auto Suppliers, China Transportation, which are expected to face clear earnings headwinds should escalation continue. Within this, examples of companies globally that are likely to be impacted by trade tariffs are numerous. In the US, among IT names, Apple (AAPL) is most exposed to production in China, along with Seagate Technology (STX), HP (HPQ) and Sonos (SONO). Meanwhile, in the auto sector many have grown more concerned about Tesla (TSLA) and in the machinery side, companies like Caterpillar (CAT), PACCAR (PCAR), and Terex Corp (TEX) have seen some form of supply chain disruption (but have primarily looked at price increases to offset).
- The impact of higher tariffs will inevitably be felt to varying degrees across the sector / sub-sector landscape. Another sector to be paying particular attention to is Global Retail, which has recently come into focus given the sector exposure to the next leg of tariffs, as well as recent earnings misses—Kohl’s (KSS), Foot Locker (FL), Inditex (ITX) and Lowe’s (LOW). The debate, now, is to what extent the all-encompassing tariff theme will further force thinning margins across this space. With a tight labor market, rising wages, and the battle for consumer wallet share between “bricks” and “clicks” raging on (and subsequently the need for last-mile shipping solutions), it’s well-documented that retailers’ margins have already endured considerable erosion.
- Include the re-escalation of tariffs, and profit margins are once again likely to absorb most of the impact once costs can no longer be passed along to consumers. Anecdotal evidence supports this claim, as commentary from the Dallas Federal Reserve in October of last year cited; “Among manufacturers, roughly 60 percent of contacts said the tariffs announced and/or implemented this year have resulted in increased input costs. The share was even higher among retailers, at 70 percent. Several contacts noted lower profit margins resulting from not being able to raise selling prices enough to offset the full cost hikes.”
- In a scenario that tariffs of 25% are imposed on nearly all goods imported from China, many additional retailers would face strong negative earnings impact.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, May 24th, 2019
As of the close of May 27th the MSCI Europe is -3.9% MTD and +11% YTD
- All eyes were on the UK last week as Prime Minister May announced that she was stepping down as Conservative leader, triggering the process to choose her successor. One can expect a new Conservative leader and Prime Minister to take office over the summer. Given May's departure, a political process to determine the Brexit end game—either by new Parliament elections or a referendum. They also expect a more binary outcome, with a higher probability of either a hard Brexit (25%) or Remain (45%). There is only a 5% chance of an orderly Brexit at this point.
- Stepping away from the Brexit related headlines and the tough sentiment in Europe, there are many single name opportunities across EU Equity Markets. If one looks at some of the defensive stocks in Europe, they have performed strongly this year and even this month. Some examples include Nestle (NESN) +25% YTD and +1.5% in May, Unilever (UNA) +15% YTD and +2% in May and Danone (FP) +17% YTD and +2.6% in May. Others like LVMH (MC) +30%, L’Oreal (OR) +21% Kerring (KER) +18% and Adidas (ADR) +43% have also generated strong results.
- Capital expenditure intentions in Europe have fallen sharply since 2018 and the risk of potential auto-tariffs remains a cause for concern in the region.
- However, even though the economic numbers in Europe are not rosy, our view remains that one should not to get too bearish as equity valuations are not expensive, sentiment is muted, and economists project a (moderate) improvement in growth going forward.
ASIA AND EMERGING MARKETS
As of the close of May 27th the MSCI Asia ex-Japan is -8.9% MTD and +3.2% YTD, and the MSCI Emerging Markets is -8.6% MTD and 2.1% YTD.
Both indices are still down -14% and -15% respectively since the end of 2017.
- Looking at China, the CSI 300 has lost -7% in May, but continues to be +20% YTD. Weakness has been largely driven by the trade conflict with the US. Last month we noted that growth seemed more stable and that was why it seemed the authorities had taken away some of the stimulus calls on the market. With the current conflict extending it seems that authorities will probably increase the stimulus calls. The Hong Kong market has lost -8.1% in May and is now only +5.6% YTD.
- Our views on the “rest of the world” EMs have slightly changed since last month and that is why we are recommending to slightly reduce our weightings. Even though EMs wills probably benefit from the looser monetary policy in the DMs, the current trade conflict could extend longer than expected causing a bearish outlook and sentiment for growth in the EMs.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, May 24th, 2019
CURRENCIES, FIXED INCOME AND COMMODITIES
- Last month we noted that “while the global growth debate rages on, what is possible is that the Fed pivot opens the path towards significant USD weakness.” this has not been the case in the months of April and May as the USD strengthened to a current level of around 1.12 against the €/EUR. Even with the tariff turmoil the currencies markets have remained extremely stable. The weak European growth indicators and the better US ones, continue to favor USD assets. In addition, the continued interest rate differential in favor of the USD, as well as the negative news elsewhere, have made the USD very resilient.
- However, as stated last month two opposing US domestic forces support the view of —fiscal policy tightening (balance sheet normalization) and monetary policy getting looser—leading to a reversal in net US inflows. A weaker USD opens the door for investors to start paying attention as EM starts to outperform on the back of a weaker dollar.
- The yield curve has continued to flatten, with the current risk-off scenario. The spread between 3-month treasuries and the 10-year narrowing to a fresh 12-year low. With Fed Fund rates at 2.5%, current 2 year rates are at 2.16%, 5 year rates at 2.12% and 10 year at 2.32%, the yield curve is now inverted all the way from the short term to 10 years.
- Also, outside of the US, the yield on Germany’s benchmark 10-year, is now negative -0.145% in yield, following weak German growth data, and the continued belief that China weakness is bad for German growth.
- Commodity markets have also strongly corrected with the risk-off market repositioning. In the oil markets, both WTI and Brent are down -8.7% and -5.6% in May (they do remain +28% YTD after the May correction). Other markets like Copper (-7.2% in May) and Gold (flat for May) have also lost all their YTD gains. In the case of Copper it is understandable that the fears of lower growth in China and a correction in cyclical stock would affect the metal. Gold, on the other hand, has not jumped, as a result of the risk off move in the markets. Some soft commodities, like soybeans – directly affected by the trade conflicts, have continued losing YTD, and are now -20% from their recent peak prices in March 2018.
- Swings in sentiment expressed in the news are becoming quite sharp; they have retreated from the optimism of the last IC at the end of April, when the S&P 500 made new highs, to a much more pessimistic tone over the risks of a trade dispute. However we would emphasize that this swing has taken place against a backdrop in which the S&P 500 is just 4% below its recent highs and the VIX volatility index is at just 16: only four points above its recent lows and a good way off levels generally associated with periods of stress.
- As mentioned earlier, bonds may be telling a more gloomy story than the equity markets. So who should we believe? And how can we appropriately distinguish genuine information from what turns out to be merely exaggerated news flow? We would acknowledge that it is becoming harder to balance the marginally more positive tone being set by economic data and stabilizing earnings against the clear tail risks arising from trade tensions and geopolitics in general. Harder still is filtering out the more extreme expressions of optimism or pessimism that nowadays seem to accompany relatively small shifts in price action. Absent a full scale tit-for-tat escalation in trade tensions, the backdrop of stable, trend-like growth will eventually regain primacy. And with it, the volume of those voices suggesting a “melt up” in asset prices may well rise again. But looking beyond the fear and greed that tends to fuel sentiment, the fact is that the global economy remains in late cycle.
- On the plus side are the signs that growth is stabilizing and the long-awaited rebound in activity—capex and trade, most particularly—is still possible for the second half of the year. Also welcome are the positive surprises from Q1 2019 U.S. GDP, some improvement in the trend in Chinese growth data (even allowing for the volatility of the month-to-month numbers) and early signs of stabilization in European data. Yet, trade fears are one plausible reason why the rebound in data has, so far, been unspectacular; and, more importantly, asset prices have already risen a good way to discount a growth turnaround. This leaves investors with an unsatisfactory combination of economic data that looks like it may be starting to improve, assets that are already discounting such an outcome and the unsavory reminder that all is still not well on the trade front.
- So what should we do? Will trade fears pass and the market quickly resume its pricing of an ever-stronger surge in growth? Or should we be accepting this is the end of the goldilocks phase in this already extended cycle and be reducing risk ? We have treated the rebound in global stocks with some caution thus far, having reduced the equity weighting already last year. We have preferred to acknowledge the easing of monetary policy and shift in the market’s direction through carry assets, like corporate credit and high yield. Should trade tensions ease and the tentative stabilization in growth gain some momentum, there is a case for a modestly more positive view on stocks. But we would still caution against the idea of going “all in” this late in the cycle. Those voices suggesting a “melt up” can sound compelling when growth data are picking up and tail risks appear to be abating. But in a late-cycle environment, there is little room for maneuver if news flow were to lurch negatively once again. And even assuming positive returns, it’s unlikely the Sharpe ratios for equities will be particularly strong.
- Over the longer run, our base case remains that there will be some de-escalation of trade rhetoric, sufficient to calm markets. Nevertheless, the background of unaligned economic objectives between the U.S. and China suggests that some elements of the current dispute will likely remain unresolved. Neither country would welcome economic harm, so it is reasonable to expect some form of agreement—or at least a path towards one—even as the war of words has heated up. Behind the rhetoric, the growth concerns of late 2018 and fears over inappropriately tight policy have meaningfully abated. As a result, we expect the second half of 2019 to be characterized by trend-like growth, easy policy, muted inflation and limited near-term risk of recession. And as the 2020 election campaign draws nearer, we would also anticipate a rather more reassuring tone for the economy and markets from the administration. In this environment, we continue to believe that credit can perform well. A diversified exposure to credit, like we have, should be maintained. We do see a better outlook for equities at the margin, with earnings revisions trending a little better and expectations for the rest of 2019 now quite achievable. Nevertheless, the level of headline risk associated with the prevailing trade rhetoric leaves us in no hurry to rush into a large equity position. But as this risk clears, we see scope for equities — particularly U.S. stocks — to trade modestly higher in the back half of the year.
Sources: Multi-Asset Solutions Weekly, JP Morgan, John Bilton, May 27, 2019. Global Reflections, by Nick Savone, Morgan Stanley, May 24th, 2019
Summary of returns (as of May 26th, 2019)